Our 2014 forecast for the
S&P 500 Index is 2,014. That may look like a big number, but it
doesn’t take a giant leap to get there. It represents 9% potential upside from
the 2013 close, driven by our estimate of 6% operating earnings growth, net 3%
share repurchases and modest expansion of the forward price/earnings (P/E)
multiple. Relative to our prior view, this represents about a 0.8 turn more in
the P/E multiple—and there is potential for more. The low dispersion of
price/forward earnings and higher company-specific risk lead us to conclude
that a more concentrated portfolio will be prudent this year.

Multiple Expansion

Since last March, we have been
sanguine on US equities. Our logic has been driven more by lack of a bear case
than the strength of the base case. We have seen three turns of multiple
expansion in the last two years as the P/E moved to 15.1 from 12.0—only the
fourth period with this level of expansion over the past 40-plus years.
Obviously, a sample size of three isn’t statistically significant, but the
prior three periods were followed by a continuation of the rally for another 12
to 24 months, as momentum typically persists. The only thing people are worried
about currently is that no one is worried about anything, which isn’t a real
worry.

In order to time the
impossible—the inflection point—we remain focused on what could cause fear
about a materially lower earnings trajectory, or even what could introduce
volatility into the earnings estimates. The answer: not much right now. We need
to see more capital spending, hiring, inventory and mergers-and-acquisitions
activity in order to be more fearful of a material earnings decline as these
costs get put in place and turn out to be imprudent. We would look for backlog
extensions from the technology and industrials companies or increases in
book-to-bill ratios as signs demand is improving and spending is imminent. The
most pronounced risks remain: demand weakness in the emerging markets, which
has been indicated by some large US multinationals; a policy error from the
Federal Reserve; and a strengthening dollar, which can be a drag on profits
earned overseas by US companies.

Above Consensus
With a 2% dividend yield, a 3%
net buyback and mid-single-digit earnings growth, a big down market is akin to
calling for a double-digit contraction in the market multiple. We don’t think
that’s likely. We are still optimistic and wouldn’t be surprised to see the
S&P 500 remain robust. Our target for 2014 will likely be above Wall
Street’s consensus. The dream of a steeper yield curve, a belief that the Fed
can distinguish between tapering and tightening, and the lack of a credible
bear case in earnings could drive further multiple expansion. Upside from
economically stronger China and Japan could also help. In fact, it isn’t
preposterous to say that we could be in an environment of synchronous global
economic expansion in 2014 that isn’t fully in today’s prices.

At the sector level, we are
upgrading materials to overweight from equal weight, a move driven by
chemicals. We are also downgrading industrials to equal weight from overweight
and lowering energy to underweight from equal weight. In addition, our strategy
recommendations include a preference for small caps over large caps, and we
recommend a barbell-like approach, holding both cyclical and defensive
companies. We prefer health care to consumer staples, technology to consumer
discretionary and chemicals to industrials and energy. Within financials, we
prefer capital-market-sensitive banks and asset managers over insurers and
regional banks.